The trade war is getting worse before it gets worse

September 20, 2018

Trade tensions between China and the United States will get worse before they get worse. There’s no going back to the pre-Donald Trump world trade order.

Furthermore, within the current geopolitical context, the World Trade Organization needs to be revamped, or its future could be in serious doubt; it’s proven itself to be toothless in the face of these trade skirmishes. Even Jack Ma, chairman of Alibaba, said recently that he thinks this trade war will last 20 years.1

What just happened

Washington announced tariffs on $250 billion on imports from China—the latest $200 billion starting with a tariff of 10% was implemented on September 24, rising to 25% on January 1, 2019. Beijing responded proportionally (the country imports many fewer goods and services from the United States than vice versa) with tariffs on $100 billion of imports from the United States.2

What and who will be hit the hardest

The first tariffs imposed on $50 billion of goods from China focused mainly on intermediate goods. This most recent round of tariffs on $200 billion of goods also includes a number of intermediate goods, but hits the consumer sector much harder. Machinery—the old-fashioned and electronic kinds—makes up the biggest basket of the tariffs. The public consultation3 saw the business lobby succeed in removing electronics—Bluetooth devices and smart watches—agriculture, health and safety products, and child safety furniture from the final tariffs.

Most economists estimate that the hit to Chinese GDP from the tariffs as of September 24 will be 0.3 to 0.4 percentage points (ppts) and that it'll be around 0.9 ppts per year from January 1, 2019, when higher tariffs kick in. Interestingly, few economists have modeled the impact of tariffs on U.S. growth, although the consensus seems to be a hit of 0.3 ppts per year.

In my view, these models are hugely flawed and don’t at all capture:

Distributional factors, both geographical and sector

Disruptions to global supply chains, the most pernicious piece of the trade war, in my view

The fact that many of these tariffs are very unlikely to ever be paid—there are a number of examples of China trans-shipping goods (more on this in a second)

The trade war expanding well beyond trade, as has already been the case—compliance and red tape have increased, and the renminbi (RMB) depreciated several factors more than that one-off devaluation back in July 2015

Importantly, the impact of the tariffs for both the United States and China should be greatest in the short term and ease over time as companies reroute their global supply chains. That being said, the longer the trade war lasts, the bigger the hit on investment as firms decide to delay capital expenditure until there’s more certainty. A number of regional U.S. Federal Reserve (Fed) presidents have reported that companies in their regions that were considering investing off the back of the tax bill are now delaying and deferring their investment because of trade.4

Tariffs are ultimately a tax on consumers, and therefore feed through into inflation. Looking at the history of trade tensions—they rarely result in the kind of inflationary pressures that some investors are worried about. The tariffs the United States will have implemented on Chinese goods as of September 24 could push core personal consumption expenditure up by around 0.03 ppts (0.08 ppts as of January 1, 2019). The real risk of trade wars is a hit to growth, not a boost to inflation; the Fed is highly aware of this and has spoken about it openly.5 Unless trade wars escalate significantly from here—imposing 25% tariffs on an additional $267 billion of goods imported from China as well as auto tariffs—drawing Europe and Japan into the dispute, for example, it’s highly unlikely the Fed will shift its rate path materially based on trade.

“The real risk of trade wars is a hit to growth, not a boost to inflation ... ”

The contagion will hit countries in China’s supply chains the hardest, particularly Taiwan, Singapore, and South Korea, as they export the most tariffed (now a verb and an adjective, in addition to a noun!) products to China to be sent along to the United States; however, a number of emerging Asia countries could benefit from this trade war as China begins engaging in trans-shipping. We have a number of examples of China exporting goods to Taiwan, South Korea, Vietnam, Malaysia, and Thailand, allowing those goods to be passed on to the United States tariff free. For instance, China took this approach with honey after the U.S. antidumping duties in 2001, and solar panels and tires after the 2009 tire tariffs under President Obama.6

Some Chinese manufacturers have recognized that U.S. tariffs make cheap goods sold to U.S. consumers a less viable business plan and are accelerating their shift to producing higher-quality products to compete with U.S. goods. This was almost certainly not the intended consequence of the U.S. tariffs, as they could end up supporting the Made in China 2025 initiative rather than undermining it.7

Where do we go from here?

For starters, the negotiations between U.S. Treasury Secretary Steven Mnuchin and China’s Vice-Premier Liu He were last proposed to be held on September 27 and 28—just days after the next round of U.S. tariffs kicks in. I think there’s very little chance these negotiations will now take place; the best-case scenario is that Vice-Premier Liu He sends a junior representative.

The People’s Bank of China (PBoC) has gone to great efforts to stabilize the RMB since early August. I don't expect this will continue to be the case if the United States imposes the tariffs it has announced. But I don't expect a sharp depreciation of the RMB immediately. The PBoC won’t want a destabilizing devaluation that puts pressure on China’s capital controls. Furthermore, the PBoC will likely continue to offer some support to its currency until the U.S. Treasury Department’s semiannual currency report is released in mid-October (although it may be delayed) to avoid being labeled a currency manipulator. Thereafter, relative to the U.S. dollar, I expect the Chinese yuan will weaken through the psychologically important 7 level.8 China recorded a current account deficit for the first time in 20 years in the first half of 2018,9 and this creates an opportunity for the PBoC to step back and accept a further market-driven weakening of the RMB. This, of course, has important implications for emerging markets (EMs) broadly, particularly if China doesn’t implement a blockbuster fiscal stimulus package, which now seems unlikely—stimulus measures at the local and regional level appears to be the preferred approach for now.

Former Finance Minister Lou Jiwei recently suggested China retaliate by imposing export restrictions on intermediate goods that the United States will have difficulty sourcing from a third country, particularly rare earth metals.10 This seems unlikely at this stage, but could be put more firmly on the table with additional tariffs imposed by the United States on Chinese goods.

Compliance, licensing, and red tape will almost certainly continue to rise for U.S. companies operating in China.

Chances for de-escalation of the trade war are slim

I would put the probability of a de-escalation at only around 20% before the midterm elections and not much better after. The White House’s China trade policy has played very well among the Republican base, and so President Trump is unlikely to back away from it unless pressured to do so by either the economy or the markets. Polls suggest the Democrats will win the House (and lose the Senate) in the midterm elections, and I agree.11 But even if that were to happen, trade policy shouldn’t change significantly; protectionism is traditionally a Democrat policy.

Furthermore, it isn’t clear what China can realistically offer to mollify the United States. From the Chinese government’s perspective, it’s already laid out a long list of concessions and the ball is in the United States’ court. If the goal is for the tariffs to push Chinese companies to stop their alleged practice of stealing Western intellectual property and to abandon the Made in China 2025 strategy, then we could be looking at two problems. First, it isn’t in China’s best interests to do this given how important it’s Made in China 2025 program is to the country’s medium-term growth strategy.5 Second, it isn’t clear what steps China can show the world it’s taking in the short term to abandon its entire industrial strategy, which is ultimately a long-term process.

Don’t expect a break from trade anytime soon

NAFTA negotiators are set to resume talks this week. There’s a sense that some progress needs to be made before the end of the week in order to send the detailed legal text to Congress by October 1 (giving Congress the requisite three months to get it passed before President-Elect Andres Manuel Lopez Obrador takes the helm in Mexico on December 1). I think we’ll see a deal done on NAFTA; this Friday, September 21, is a soft deadline, although there isn’t much wiggle room because it does take time for the legal text to be drafted.

Meanwhile, Japan and the United States will hold their second round of trade talks on September 21, followed by a meeting between Prime Minister Shinzo Abe and President Trump on September 26. Japan, which has a current account surplus with the United States, has managed to fly under the radar on trade recently. Prime Minister Abe tread very softly when the steel and aluminum tariffs were imposed, refusing to retaliate. Still, the United States and Japan have a history on trade—U.S. Trade Representative (USTR) Robert Lighthizer was deputy USTR in the 1980s when the United States forced export caps by threatening to impose tariffs on Japan; I believe there’s almost no chance of Japan going down this road of export caps again. Instead, it seems likely Japan will stick to the tariffs that were already agreed in the Trans-Pacific Partnership, from which the United States withdrew when President Trump took office.

Don’t forget that auto tariffs on Europe are still lurking out there as well. If the United States decides to impose tariffs on European cars, I doubt the European Union will sit there and do nothing—retaliation would be almost certain.

1 “Alibaba’s Jack Ma warns trade war could last 20 years,” Financial Times, September 18, 2018. 2 “China hits back at Trump with tariffs on $60bn of US goods,” BBC, September 18, 2018. 3 As part of the consultation, the United States Trade Representative (USTR) created a process for businesses and the public to obtain product-specific exclusions from tariffs on Chinese imports. 4 “Fed: Letting inflation run too hot could lead to a significant economic downturn,” July 5, 2018. 5 “Fed’s Kaplan ‘calling out’ U.S. tariff risk before it worsens,” Reuters, July 13, 2018. 6 “Chinese producers expected to beat U.S. tariffs by rerouting goods,” Nikkei Asian Review, September 18, 2018. 7 Why ‘Made in China 2025’ triggered the wrath of President Trump,” South China Morning Post, September 11, 2018. 8 “Trade war could become currency war depending on how China fights back,” CNBC, September 17, 2018. 9 “Amid trade war, China records first current account deficit in 20 years in H1 2018,” Financial Express, August 7, 2018. 10 “China Could Ban Exports of Products Crucial to U.S. Manufacturers, Former Finance Minister Says,” Caixin, September 17, 2018. 11 FiveThirtyEight, as of September 19, 2018.

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